Small Business Finance Test 2

Why should we use caution when making decisions based on a company's financial statements?

Accounting rules and standards are always changing, the values of the assets included on the books are generally based on the cost of that asset. The book value indicated by the balance sheet of a business rarely reflects the market value. Lastly, financial statements are created by people, and people can lie or make errors

Audited financial statements

Audited financial statements have been successfully formally examined by an outside, independent auditor. Examination includes an in-depth investigation of a business's accounting policies and practices, accounting records, and internal financial statement

How is an ending owner's equity balance determined? How is an ending retained earnings balance determined? What's the primary difference between the two calculations?

Begin with last year's ending owner's equity balance. Add any equity investment in the company that has occurred during the current year. Add the business's net income or deduct the business's net loss for the current year. Deduct any distributions paid to the owner during the current year. Alternatively, begin with last year's ending retained earnings balance. Add the business's net income or deduct the business's net loss for the current year. Deduct any dividends (C corporation) or distributions (S corporation) paid to shareholders during the current year.

Profitability Ratios

Measures of the operating success of a company for a given period of time.

balance sheet

The statement of financial position (also called the balance sheet) is a summary of the assets, liabilities, and equity of a business at a specific point in time.

Describe what a schedule of start-up costs is and how it is created.

With a preliminary list of start-up costs in words, the next step is to attach a number, a realistic, researched dollar amount, to each item on the list. Each cost item should be supported with at least one meaningful and respected source of information and a time frame, as applicable. After our entrepreneurs have assigned a dollar amount to each item on the preliminary list of start-up costs, they flesh out that list based on their ongoing industry research in order to develop the finalized list of start-up costs

Working capital

Working capital is calculated by subtracting a company's current liabilities from its current assets Working capital = Current assets - Current liabilities Positive working capital is an indicator that a company has the ability to pay its obligations in the short run. Negative working capital indicates a company faces short-term challenges with regard to paying its bills.

fixed cost

a cost that does not change, no matter how much of a good is produced

variable cost

a cost that rises or falls depending on how much is produced

accounts receivable turnover ratio

a ratio that indicates how fast a company is turning its credit sales into cash"

Return on Equity

a ratio that indicates how much profit a firm is earning on the amounts invested in the company—and the profits retained in the company—by the company's owners, calculated as a percentage of the company's equity

debt-to-total assets ratio

a ratio that indicates what percentage of a business's assets are owned by its creditor"

Cash flows from investing activities

a section of the statement of cash flows that typically includes summary information regarding the purchase or sale of investments in the financial markets, the purchase or sale of fixed assets, the making or collection of loans, and any insurance settlement proceeds related to fixed assets

Cash flows from financing activities

a section of the statement of cash flows that typically includes summary information regarding the sale or repurchase of stock, the receipt of debt proceeds or the repayment of debt, and the payment of dividends or distributions "

net income before income taxes

a subtotal unique to the income statement of a C corporation or entity taxed as a C corporation that usually appears immediately before the line for the provision for income taxes

earnings per share of common stock

an element sometimes included on the income statement of a C corporation (but not on the income statement of an entity taxed as a C corporation) calculated by dividing net income by the number of the corporation's outstanding shares of common stock

Balance Sheet Accounts

asset, current asset, prepaid asset, fixed asset, accumulated deprecations, net fixed assets, liability, current liability, accounts payable, short term portion of long term debt, long term liability, equity, paid in capital, retained earnings

breakeven

breakeven is the point at which that business's net income equals zero.

current ratio

current ratio is an indicator of a company's ability to pay its obligations in the short run. The current ratio is calculated by dividing a company's current assets by its current liabilities: Current ratio = Current assets ÷ Current liabilities"

gross margin

gross margin is the percentage of each dollar of net sales (or sales, if there is no net sales amount) that remains after cost of goods sold has been considered. The formula is as follows: Gross margin = Gross profit ÷ Net sales

Compiled financial statements

have been prepared by an accountant outside a company based upon the data provided by that company. An accountant who prepares compiled financial statements does so without providing any of the assurances associated with an audit or a review.

Reviewed financial statements

have been subjected to inquiry and analytical procedures by an outside accountant who expresses limited assurance that the financial statements fairly present the financial position, performance, continued viability, and risks associated with the company under review. A review is a "does it make sense?" analysis that's useful when an organization needs some assurance about the adequacy and fairness of its financial statements—but not the higher level of assurance provided by an audit.

Activity Ratios

how well the company is managing its assets

times interest earned ratio

illustrates the relationship between the amount of interest a company must pay its creditors on an annual basis and a company's annual operating income. Here's the formula: Times interest earned = Operating income ÷ Interest

horizontal analysis

is a determination of the percentage increase or decrease in each line item on a financial statement from a base time period to a successive time period. The formula is: Percentage change = [(New amount - Old amount) ÷ Old amount] x 100

Vertical analysis

is the process of using a single line item on a financial statement as a constant and determining how all the other line items relate as a percentage of that constant. A vertical analysis of an income statement is typically used to determine how much of a company's net sales (or sales, if there is no line for net sales) is being consumed by each line of the income statement. If the constant is net sales, then the formula is: Percentage of net sales = (Amount of applicable income statement line item ÷ Net sales) x 100 for the balance sheet use total assets

debt-to-equity ratio

ratio that indicates what percentage of a business's assets are financed with debt compared to equity

liquidity ratios

ratios that indicate how much of a firm's current assets are available to meet short-term creditors' claims

Reserve for Bad Debts

reserve for bad debts is an estimate of the amount of the accounts receivable included on the balance sheet that won't be collected, typically included on a balance sheet as a contra-asset account to accounts receivable

leverage ratio

role of debt in financing the activities of a business

Inventory Turnover Ratio

suggests how fast a firm is moving its inventory. It indicates how many times per year, on average, a company sells—and therefore must replace—all of its inventory."

What is breakeven revenue, and why should every entrepreneur calculate it for any new venture she's considering starting?"

Breakeven Revenue = Total Fixed Costs / Gross Margin Every entrepreneur should calculate breakeven revenue to determine if the venture is worthwhile.

Income Statement Accounts

Sales Revenue, returns and allowances, net sales, COGS, cost of sales, gross profit, operating expenses, depreciation expense, operating income, interest expense, provisions for income tax, net income

Average Collection Period Ratio

Tells the average number of days required to collect accounts receivable.

Income Statement

The income statement is a summary of the revenue and expenses of a business over a specified period of time.

mixed cost

a cost that contains both variable and fixed cost elements

profit margin

the percentage of each dollar of net sales (or sales, if there is no net sales amount) that remains after all expenses, including interest and taxes, have been considered

four methods of financial statement analysis

vertical, horizontal, ratio, breakeven

cash flows from operating activities

• considers a business's net income or net loss • adds back depreciation expense to net income or net loss because depreciation is a non cash expense • identifies all the cash received and paid out by the business as a result of its day-to-day operations during a specified period by identifying the dollar change in non cash current asset and current liability balance sheet line items from the beginning of the period to the end of the period

Explain how an S corporation's accounting practices and financial statements illustrate the hybrid nature of that legal form.

On its balance sheet, an S corporation looks like a C corporation. This is because, like a C corporation, an S corporation issues shares of common stock. Therefore, the equity section of the balance sheet of an S corporation will include line items for common stock and retained earnings. The equity section may also include a line item for paid-in capital in excess of par. The equity section of the balance sheet for an S corporation will not, however, include a line for preferred stock, as S corporations are precluded from issuing preferred stock because they may have only one class of stock and must issue common stock. In its accounting practices, an S corporation is like a partnership. This is because details regarding the balances of the individual shareholders' capital accounts must be maintained and reported on various required annual individual and summary tax schedules.

Why does an entrepreneur need to create pro forma financial statements?

Potential investors typically request pro forma financial statements for at least three to five years into the future in order to determine if a business is a good choice for their investment dollars. Before they'll consider lending to a business or guaranteeing a loan to a business, most lenders and the Small Business Administration will typically require the same. As business owners, we use the pro forma financial statements we create for our own purposes. We use them to develop internal budgets for our business, plan for its future, and make sure we have the resources we need to grow the business.

What are the three traditional pro forma statements for a for-profit business?

Pro Forma Income Statement Pro Formal Balance Sheet Pro Forma Statement of Cash Flows

When creating comparative balance sheets, there are a few special items to salvage value remember. List and describe those items

Salvage value is the amount for which an asset is expected to be sold after a business has fully depreciated the asset and ceased using it. The straight-line depreciation method indicates that one would take the cost of an asset or group of assets, divide that asset or group of assets by the expected useful life of the assets or group of assets, and the result would represent annual depreciation expense.

Return on Assets Ratio

Tells us how much profit a firm is earning on its assets.

What detail schedules typically need to be created in conjunction with the creation of pro forma financial statements?

The entrepreneur develops a schedule of start-up costs as a result of industry research, research performed to provide insight regarding the size and complexity of an industry, the number and nature of its participants, and the economic, political, market, and other factors that affect it. This research involves a variety of aspects such as reading industry trade journals and other trade association publications and reaching out to trade associations for detailed follow-up information, as needed, attending industry trade shows to assess which companies currently dominate the industry, which companies are up-and-comers, and which individuals are considered industry experts

statement of cash flows

The statement of cash flows is a summary of the cash receipts and cash expenditures of a business over a specified period of time."

When you're asked to create pro forma financial statements for your start-up company, don't prepare statements of cash flows, and postpone creating balance sheets for years 2-5. There are multiple reasons for this rather nontraditional approach. The reasons to not prepare statements of cash flows are as follows:

■ A reconciliation of cash is usually an acceptable replacement for a statement of cash flows. ■ A cash flow issue will identify itself in the form of a negative cash balance on the reconciliation of cash and the pro forma balance sheet. ■ Creating formal statements of cash flows is time-consuming and challenging work. We can always instead create additional detailed pro forma balance sheets and income statements as their creation becomes warranted

The reasons to postpone preparing balance sheets for years 2-5 are as follows

■ Balance sheets are much more time consuming and difficult to create than income statements. ■ Pro forma balance sheets tend to get more and more unrealistic as we proceed further and further into the future. ■ Every time the pro forma income statements (or early pro forma balance sheets) are updated with new information, every existing pro forma balance sheet, reconciliation of cash, reconciliation of equity, and statement of cash flows dated on or after that change will also have to be updated. ■ Investors and lenders spend most of their time looking at income statements and very little time looking at balance sheets.

preliminary list of start-up costs related to the business

■■ rent ■■ utilities ■■ business insurance ■■ store design and decoration ■■ clothing inventory ■■ accessories inventory ■■ checkout counters and furniture ■■ clothing racks and shelving ■■ computers and software ■■ security system"